In this post, we'll cover how to account for inflation in retirement planning.
To pursue a stable financial future, planning for inflation is critical. Future inflation rates may be higher than those today, so it's important to create a conservative plan that considers all likely possibilities.
You don't want to discover that your pension income, social security benefits, or other income streams are insufficient after you've already retired.
A solid retirement plan takes into account your current and future income and expenses, current and future inflation rates, compound interest, and your risk tolerance profile among other considerations.
If you're 3-5 years from retirement, we strongly recommend that you work with a financial advisor or financial planner to create a financial plan and investment portfolio that is designed with inflation in mind.
This post is not intended to be a substitute for professional financial advice. Use this as a starting point, but do seek the advice of a financial planner, retirement advisor, or financial advisor.
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How Can I Account for Inflation When Planning for Retirement?
Inflation is an unavoidable reality that erodes the value of money over time.
When planning for retirement, ignoring inflation can jeopardize your ability to maintain your desired lifestyle. As costs rise, what may seem like a sufficient nest egg today could fall short decades down the line.
A proactive approach will seek to ensure that your retirement savings not only last but also maintain their purchasing power in the face of rising expenses. This requires careful planning, strategic investments, and ongoing adjustments to align with inflationary trends.
Follow the steps below to get started. And take the 2-minute quiz to see if you're ready for retirement.
Steps to Follow to Account for Inflation When Planning Retirement Income Streams
Here’s what you—and your financial planner—should focus on to preserve your financial future:
1. Build Inflation-Adjusted Projections
Account for future costs in today’s dollars.
Estimate your retirement expenses using today’s prices, then adjust them upward based on expected inflation rates. For instance, if healthcare costs are projected to grow at 5% annually, plan for a larger allocation toward medical expenses.
2. Diversify and Balance Your Investments
Work to ensure your portfolio includes inflation-resistant assets.
Work with your planner to maintain a diversified portfolio with the following elements:
Stocks: Include equities for growth potential, as they historically outpace inflation. Dividend-paying stocks are particularly beneficial for retirees.
Treasury Inflation-Protected Securities (TIPS): These bonds adjust for inflation and are a reliable way to preserve purchasing power.
Real Estate: Consider real estate investment trusts (REITs) or direct property investments, as real estate often appreciates faster than inflation.
Commodities or Inflation-Hedged Funds: Investments in commodities like gold or funds tied to inflation indices can provide additional confidence.
If you are working with a fiduciary financial advisor or wealth advisor, they will create your balanced portfolio based on your risk tolerance and goals.
3. Create Flexible Withdrawal Strategies
Avoid rigid withdrawal rates.
Rather than sticking to a fixed percentage like the 4% rule, collaborate with your financial planner or financial advisor to create a flexible approach.
4. Account for Healthcare Inflation
Plan for rising medical and long-term care costs.
Healthcare inflation typically outpaces general inflation, so it’s critical to set aside sufficient funds. Options include:
Health Savings Accounts (HSAs): These tax-advantaged accounts allow you to grow savings for medical costs.
Long-Term Care Insurance: Purchase a policy to offset the potential financial burden of extended care.
5. Revisit and Rebalance Regularly
Inflation isn’t static. Your financial plan shouldn't be static either.
Work with your financial planner or financial advisor to rebalance your portfolio at least annually.
6. Minimize Taxes in an Inflationary Environment
Inflation can increase your tax burden, so plan accordingly.
Consider using tax-advantaged accounts like Roth IRAs or municipal bonds to minimize taxes on your income. Your financial planner can also help you employ strategies like tax-loss harvesting to reduce taxable income.
Now that we've covered the basic steps you can take with your financial advisor or financial planner, let's dig into the topic of inflation and retirement planning a little more deeply.
Understanding Inflation and How It Affects Retirement Income
Inflation represents the gradual increase in prices over time.
This phenomenon decreases the purchasing power of money, making goods and services more expensive. For retirees, this is particularly significant because they often rely on fixed income sources.
Without inflation-conscious planning, retirees risk falling short of covering their essential needs. A thorough understanding of inflation’s impact is essential for developing a financial strategy that prioritizes both security and flexibility.
What Causes Inflation?
Inflation is typically driven by demand-pull or cost-push factors.
Demand-pull inflation occurs when consumer demand outpaces supply, driving up prices.
Cost-push inflation happens when production costs rise, such as price increases of raw materials, forcing businesses to charge more.
Additionally, factors like monetary policies, global supply chain disruptions, and geopolitical tensions can exacerbate inflationary pressures. Recognizing the reality of these drivers helps retirees and planners prepare for periods of heightened inflation.
How Inflation Impacts Retirees
Rising costs present unique challenges for retirees.
Fixed income sources like pensions or annuities may not adjust for inflation, diminishing their real value over time. Essentials such as housing, groceries, and healthcare often rise faster than general inflation rates, creating a financial pinch for retirees.
Planning for inflation is key if you want to make sure that your retirement funds keep pace with rising costs and help retirees avoid compromising their standard of living.
Key inflationary challenges for retirees include:
Unpredictable costs: Essentials like energy, housing, and medical care may outstrip general inflation.
Fixed income limitations: Pension and annuity payments may remain stagnant even as prices rise.
Addressing these challenges requires a mix of inflation-protected investments, diversified income streams, and regular financial reviews.
How Inflation Impacts Purchasing Power
Purchasing power refers to how much a dollar can buy at any given time.
As inflation rises, the same amount of money buys fewer goods and services. For example, $2,000 today might cover monthly expenses, but in 20 years, that same amount might only cover 60% or less of those costs.
As you head into retirement, you must plan for this erosion to avoid shortfalls. Investing in assets that outpace inflation, such as stocks or real estate, and maintaining flexibility in spending can help preserve purchasing power over the long term.
The Role of Equities in Inflation Protection
Equities seek to outperform inflation over the long term.
Stocks provide growth potential that can help maintain or increase the real value of retirement savings. While they carry short-term risks, equities can be a powerful hedge against inflation when held in a well-balanced portfolio.
High-quality dividend-paying stocks seek to offer a combination of income and growth, making them particularly valuable for retirement-aged investors.
Bonds and TIPS to Hedge Against Inflation
Fixed-income investments can offer stability and inflation protection.
Treasury Inflation-Protected Securities (TIPS) are government bonds that adjust their principal based on inflation, working so your investment keeps pace with rising costs. Similarly, high-quality corporate bonds and inflation-linked annuities may provide reliable income streams. Incorporating a blend of TIPS and traditional bonds into your portfolio can help balance risk and return while safeguarding against inflation.
Benefits of incorporating TIPS in retirement planning:
Inflation-adjusted returns: TIPS are designed to match inflation rates, preserving purchasing power.
Government-backed security: As a US Treasury product, they carry minimal credit risk.
Diversifying Income Streams for Inflation Protection
Relying on a single income source can leave retirees vulnerable.
Diversifying income streams spreads risk and reduces reliance on any one source that may lose value due to inflation. This approach not only enhances financial stability but also offers investors greater flexibility to adapt to rising costs.
The Importance of Portfolio Rebalancing
Rebalancing your portfolio annually is critical.
Market fluctuations and inflation can shift the balance of your portfolio, potentially increasing your exposure to unwanted risks. Regularly reviewing your asset allocation and rebalancing seeks to ensure that your investments continue to align with your financial goals.
This process might include shifting funds into inflation-resistant assets or scaling back on those that no longer serve your long-term needs.
Adjusting Withdrawal Strategies for Inflation
A flexible withdrawal strategy can extend the longevity of your savings.
Rigid withdrawal rates may lead to premature depletion of retirement funds, especially during inflationary periods. Adjusting withdrawals based on market performance, inflation rates, and personal needs can help ensure your savings last.
In addition, a holistic risk-based guardrails strategy or a withdrawal-rate guardrails approach can be followed. With these strategies, withdrawals are modified within predefined limits and will aim to provide investors with both stability and adaptability.
Accounting for Rising Healthcare and Long-Term Care Costs
Healthcare costs often outpace general inflation rates.
Medical expenses can be a significant financial burden for retirees, with costs for prescriptions, treatments, and long-term care rising faster than overall inflation. Planning for these expenses requires dedicated savings, long-term care insurance, or health savings accounts (HSAs).
Proactively addressing healthcare costs seeks to ensure retirees are better prepared for one of the most significant financial challenges in retirement.
Tax Considerations in an Inflationary Environment
Inflation can subtly increase your tax burden.
Higher portfolio withdrawals or income adjustments for inflation may push retirees into higher tax brackets. This can erode the value of growth potential faster than anticipated. Utilizing tax-advantaged accounts like Roth IRAs, which offer tax-free growth potential and withdrawals, can mitigate this risk.
Additionally, retirees should consider tax-loss harvesting or municipal bonds to reduce their overall tax liability.
Work with a CPA and financial advisor to do effective tax planning.
Work with a Wealth Management Firm
Professional guidance can help you navigate inflation’s complexities.
Wealth advisors can provide tailored strategies that seek to counter inflation. They can align investments with your retirement goals and risk tolerance. They can also monitor market conditions, rebalance your portfolio, and recommend adjustments that seek to ensure your financial plan remains on track.
Partnering with a wealth management firm is particularly important if you have a complex financial situation or a high income. A good wealth management firm will help you with your tax planning and estate planning as well as managing your investments and creating a financial plan.
Common Questions
Should I account for inflation in retirement planning?
Yes, inflation is a critical factor in seeking to ensure your retirement savings retain their value over time.
If you don't account for inflation when doing your retirement planning you risk running out of money later in life.
How do I account for inflation in retirement?
Incorporate inflation-adjusted projections into your savings goals, investments, and withdrawal strategies.
If you're not a personal finance nerd, then we recommend that you work with a financial planner or financial advisor who can do this for you and act as your guide and advisor over the long term.
What is the 4% rule?
The 4% rule is a retirement planning guideline that helps determine a safe withdrawal rate from your savings.
It suggests that retirees can withdraw 4% of their total retirement portfolio in the first year of retirement, then adjust that amount annually for inflation. This approach is designed to make your savings last for at least 30 years.
For example, following this rule, if you were to retire with $1 million, you would withdraw $40,000 (4%) in the first year. In subsequent years, you would continue to withdraw 4% each year. This would allow your withdrawals to keep pace with inflation.
While the rule provides a general framework, it may need adjustments based on factors like current inflation rates, market performance, and your individual financial situation. The 4% rule has its limitations and shouldn’t be taken as a hard-and-fast rule.
What is the 25x rule?
The 25x rule is a retirement savings guideline used to estimate how much money you need to retire comfortably.
It suggests that you should save 25 times your annual retirement expenses to pursue financial security. For example, if you expect to spend $50,000 per year in retirement, you would aim to save $1.25 million ($50,000 × 25).
This rule is based on the assumption that you will withdraw 4% of your portfolio annually (the 4% rule), which is designed to make your savings last at least 30 years while accounting for inflation and market fluctuations. However, during periods of high inflation or market instability, adjustments to this rule may be necessary to avoid depleting your funds prematurely.
Keep in mind that if you retire early and live well past the age of 85, you may not have sufficient funds if you simply follow the 25x rule.
Working with a financial planner or financial advisor is important because they can use financial modelling tools to look at various outcomes depending on when you retire and how long you live. We strongly recommend having a solid financial plan in place and updating it regularly.
Is the 25x retirement rule still reliable during high inflation?
It remains a useful guideline but should be supplemented with flexible strategies and regular reviews.
How can I safeguard my retirement accounts against inflation?
Consider diversifying your portfolio with equities, TIPS, and real estate investment trusts.
Also look at adjusting your withdrawal strategies and maximizing inflation-adjusted income streams (e.g., Social Security). Finally, make sure you are regularly rebalancing your portfolio to align with inflationary trends.
Do real estate investment trusts act as a hedge against inflation?
Yes, REITs can act as a hedge since real estate values and rental incomes often rise with inflation, preserving purchasing power and providing a potential source of inflation-adjusted income. However, this is just one strategy and should not be the only thing you do to hedge against inflation.
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About 360 Financial
360 Financial is an independent wealth management firm with a team of specialized financial advisors and financial planners. As fiduciaries, 360 Financial’s advisors provide services to business owners, entrepreneurs, and professionals. We help investors with sudden wealth, retirement planning, tax planning, estate planning, and business financial planning.
Headquartered in Minnesota, we serve investors across the US with online and in-person wealth management and financial planning services.
Important Notes about Investing
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.
Investing involves risk including loss of principal. No strategy assures success or protects against loss. Dividend payments are not guaranteed and may be reduced or eliminated at any time by the company.
There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.
The fast price swings in commodities will result in significant volatility in an investor’s holdings. Commodities include increased risks, such as political, economic, and currency instability, and may not be suitable for all investors.
Investing in Real Estate Investment Trusts (REITs) involves special risks such as potential illiquidity and may not be suitable for all investors. There is no assurance that the investment objectives of this program will be attained.
Municipal bonds are subject to availability and change in price. They are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise. Interest income may be subject to the alternative minimum tax. Municipal bonds are federally tax-free but other state and local taxes may apply. If sold prior to maturity, capital gains tax could apply.
